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By Stefano Rebaudo
Nov 24 (Reuters) - A turning point for peripheral euro zone government bonds appears to be underway as more enticing yields and a European Central Bank backstop could rein in the risk premium for Southern European debt.
The coming year will provide a real test, as investors shift their focus to bond supply and what the ECB does in terms of quantitative tightening, starting as soon as the central bank's next policy meeting on December 15, when it will likely raise interest rates again.
The ECB is debating when to start selling off its holdings of government debt, but is still keeping its Transmission Protection Instrument (TPI) in place.
The TPI is there to stop any euro zone member's bond yields from spiking suddenly, which could threaten the ECB's ability to make monetary policy effective across the region.
“There is a lot of money on the sidelines, and investors are revisiting their assumptions. If inflation and bond volatility gets under control, they will begin to add high-yield sovereign bonds to their fixed income portfolio,” said Niall O’Sullivan, CIO of multi-asset strategies at Neuberger Berman.
“In the short-term, we are a bit cautious on Italy as its bonds rallied a lot, but we are still favourably disposed towards Spain and Portugal,” he added.
Rising rates would normally hit peripheral bonds harder than core. But the spread between yields on benchmark German Bunds and those of more indebted countries has narrowed recently, defying that rule of thumb.
The 2-year German Schatz yield is trading around 2.1%, not far off a 14-year high of 2.25% hit a couple of weeks ago. It's risen by 273 basis points so far this year, 32 of those in this quarter alone.
Italian 2-year bonds meanwhile, have risen 279 bps this year, but have actually dropped 14 bps so far in the fourth quarter.
Sovereign and corporate bonds have also been moving in opposite directions, as government bond spreads have tightened, while those on company bonds have widened.
Reprinted with permission of Citi Research. Not to be reproduced.
"Furthermore, the negative correlation between peripheral yield gaps and equities has reasserted itself this year, showing that rising risk appetite has also boosted demand for peripheral bonds. It has been the case with Italian BTPs, but also with Spanish Bonos and Portugal’s government bonds.
But this outperformance hinges on a number of factors.
Chris Attfield, a rate strategist at HSBC, mentioned as primary triggers for a potential spread widening “a more hawkish ECB, continued challenging supply conditions, and a potential worsening of debt sustainability metrics due to high yields and a possible recession.”